The global crisis has exposed the frailty of financial sectors the world over and highlighted the need for regulatory reform. This column argues that taxing banks is no panacea. The only way to achieve financial stability and financial integration in Europe is to move towards a European-level bank resolution framework that has both funding and intervention authority.

The political debate on regulatory reform of the financial sector has found a new focus on both sides of the Atlantic: taxation!

What regulators and supervisors were not able to achieve, the taxman is now supposed to fix – forcing banks to take less risks while at the same time replenishing government coffers that have been depleted by the recent crisis. The new taxes are supposed to finance the recent bailout, prevent market-distorting speculation, and reduce the systemic risks posed by large banks.

But can financial sector taxes really do all of this? A recent IMF report (Cottarelli 2010), as well as suggestions by the US administration (White House 2010) and the EU Commission (2010), offer very different approaches. The recent u-turn by the German government in favour of a financial transaction tax has complicated the international debate further.

There are good reasons to reconsider taxation in the financial sector. The financial crisis has made it clear that the prosperity of Main Street and Wall Street are closely linked – and that should also be reflected in the taxation of the sector. Taxes can also supplement the current regulatory tools in the design of a stable and efficient financial sector.

But despite what some politicians seem to be suggesting, financial sector taxes are not a panacea and the proposed bank levy – as well as some other models currently discussed – pose their own risks.

Taxes can serve two very different purposes. They can create government revenues or they can influence behaviour by making socially unwanted behaviour relatively more expensive. This distinction between fiscal and behavioural purposes can help organise the currently discussed concepts of financial taxes while also highlighting some of the trade-offs that policymakers face.

The financial crisis has imposed a massive burden on government budgets worldwide. In Germany alone, the government has had to commit an amount equivalent to 24% of GDP to save the banking sector from collapse. All this has to be financed. The proposal by the Obama administration to impose a crisis responsibility levy is aimed most clearly at the refinancing of the costs incurred in the crisis. Beyond this specific need for refinancing, there are also calls for a more systematic reassessment of the taxation of the financial sector. Especially the exemption of the financial sector from VAT which leads to structurally lower tax revenues from the financial sector compared to other economic sectors that could be offset by an additional levy.

Let us first discuss the financial transaction tax, the grand old lady among the competing models. The original Tobin tax was supposed to throw sand into the overheated gears of the global financial system and to limit speculation by reducing velocity and volume of transactions (Tobin 1978). In the wake of the financial crisis, increasingly, its considerable revenue potentials have also come into view. Today, many proponents have grown uneasy with its anti-speculation merits, but emphasise that even a relatively low tax rate on a broad range of financial transactions would already raise a large revenue volume, with little distortion of capital flows.

Transaction taxes are too crude an instrument to prevent market-distorting speculation. On the contrary, by reducing trading volume they can distort pricing since individual transactions will cause greater price swings and fluctuations. But above all, not every transaction is a market-distorting speculation. Speculation is not easy to identify: What is the market-distorting bet: against or on a Greek government bankruptcy? Were the losses of the banks in the US sub-prime sector, speculation or just bad investment decisions? What is the threshold of trading volume beyond which it is speculators and not participants with legitimate needs that drive the market price for corn, euros, or Greek government bonds?

Since taxes cover the general, but not the specific case, they are an inappropriate tool to tackle market-distorting speculation. The regulatory toolbox offers much more effective tools, such as trading regulations or capital controls. The need to regulate international capital flows is a good example. Since the experience of the Asian crisis, most economists would agree that fully liberalised capital flows bring more risks than benefits and that selective controls – especially those targeting the maturity structure of capital flows – can have a stabilising effect (Ostry et al. 2010). But would a global transaction tax allow such a control? The general taxation of all currency transactions and cross-border capital flows would increase the cost of all investments across all countries – no matter whether such flows are desired by the recipient country or not. Transaction taxes on international capital flows are not only too general to reduce risks – they also undermine the rights of capital-importing countries. In a world where China is the largest capital exporter, and many developing countries are becoming increasingly self-confident market participants, this idea has an unpleasant Eurocentric aftertaste. Instead of a general taxation of capital flows in developed countries, targeted and selective capital controls by the recipient countries are the more appropriate instrument.

Most importantly, however, financial transaction taxes are not the right instrument to reduce risk-taking and fragility in the financial sector as all transactions are taxed with the same rate, independent of their risk profile.

Bank levies – taxation of risk, but no risk insurance!

The too-big-, too-important-, too-interconnected-to-fail phenomenon, i.e. the impossibility to allow failure of certain financial institutions, results in the privatisation of profits, but socialisation of losses. This in turn creates moral hazard, with the result of aggressive risk taking and less than optimal risk management. Financial policy requires better mechanisms and tools to encourage financial institutions to internalise the social costs of their risk decisions and potential failure. The task is large and requires the entire spectrum of possible policy instruments.

First, there are additional capital requirements, which should progressively increase with the size and systemic importance of financial institutions.

Second, regulatory requirements such as the “Volcker rule” to separate classic intermediation business and proprietary trading in securities, provide the opportunity to build additional firebreaks. Taxes can set additional incentives to internalise the social costs of failure by imposing taxes on the too-important-to-fail status. In many ways taxes are preferable to restrictions and prohibitions, as they force to balance private benefits and social costs of size and scope of financial institutions (see Beck 2010 for more detailed discussion).

This regulatory logic only works, however, if there is no tit for tat. Taxes or bank levies should not constitute insurance. A bank levy that goes into a failure resolution fund to finance future bank bail-outs is the wrong step, since it turns an implicit guarantee into an explicit one. Today the market still has to take into account a residual risk that the state does not intervene – as in the case of Lehman Brothers, but the proposed new mechanism would effectively force the authorities to intervene and bail-out investors (see Schoenmaker 2010). If there are constitutional limits to use special taxes for the general budget, such as in Germany, alternative financing tools have to be considered.

A better solution

A better alternative would be to transform the system of deposit insurance and its pricing structure. Such a solution could be a first step to link banks’ contributions to the deposit insurance system with the risks and the size of financial institutions. A solution, such as the least-cost-principle, applied by the Federal Deposit Insurance Corporation, would continue to protect only small savers, while other market participants would retain at least a small incentive to assess risk properly as they are exposed to losses. In particular, residual claimants such as shareholders must bear the full loss.

Any solution can only make sense on the European level. First, multilateral control in the EU, including competition rules, can provide credible safeguards that prevent the use of insurance funds for an explicit bailout and, second, the increasing cross-border nature of European banking calls for a European regulatory solution.

As my co-authors and I discuss in Beck et al. (2010), the current crisis has shown the deficiencies and gaps in the European bank resolution framework and there will be no viable alternative to moving towards a European-level bank resolution framework that entails both funding and intervention authority, this way allowing Europe to overcome the financial trilemma (Schoenmaker 2009).

Editors note: This column is based on an earlier column in German (“Steuern in der Finanzmarktpolitik – Die Spreu vom Weizen trennen”), published on www.oekonomenstimme.org